The Impact of Sec. 897 on an NRA or Foreign Corporation’s Sale of Domestic Stock

By Joseph M. Calianno, Grant Thornton LLP, Washington, DC, Member, AICPA International Tax Technical Resource Panel, and Chair, AICPA International Mergers & Acquisitions Task Force; and Kagney Petersen, Grant Thornton LLP, Washington, DC

Foreign corporations and nonresident alien individuals (NRAs) frequently invest in the United States via the stock of domestic corporations. When they make such an investment, in addition to considering the U.S. international tax implications of distributions from such entities, they must also consider the U.S. federal tax implications of a subsequent disposition of their interest in a domestic corporation.1 Subject to certain exceptions, an NRA or foreign corporation’s taxable sale of its domestic corporation stock normally results in a foreign source gain or loss under Sec. 865(a) that is not subject to U.S. taxation.2

One of the notable exceptions to this general rule, however, occurs when the domestic corporation’s stock is stock of a U.S. real property holding corporation (USRPHC). Sec. 897(a) generally provides that a foreign person’s gain or loss from the disposition of a U.S. real property interest (USRPI) is treated as gain or loss that is effectively connected with a U.S. trade or business. Subject to certain exceptions, a USRPI includes an interest (other than solely as a creditor) in a USRPHC. Generally speaking, a USRPHC is a domestic corporation that primarily holds USRPIs. Secs. 882(a) and 871(b) subject foreign corporations and NRAs, respectively, to U.S. taxation on their income effectively connected with a U.S. trade or business. Thus, an NRA or foreign corporation’s gain or loss on the sale of domestic stock may be treated as effectively connected income of a U.S. trade or business under Sec. 897. When it is, such gain or loss normally is brought within the U.S. tax system.3

In addition, Sec. 1445(a) generally requires the person acquiring a USRPI from a foreign person to deduct and withhold tax equal to 10% of the amount realized on the disposition (special rules apply under Sec. 1445(e) for certain distributions by certain entities). However, Sec. 1445(b) provides exemptions from this withholding requirement, some of which are discussed below.

This article highlights some of the important issues under Sec. 897 when an NRA or foreign corporation sells stock of a domestic corporation, focusing primarily on when a domestic corporation is treated as a USRPHC and the requirements needed to establish that such an entity is not a USRPHC.4

USRPI/USRPHC

Generally speaking, Regs. Sec. 1.897-1(c)(1) provides that a USRPI is an interest, other than an interest solely as a creditor, in real property (including an interest in a mine, well, or other natural deposit) located in the United States or the Virgin Islands. Some typical examples include certain noncreditor interests in land, improvements on land (e.g., a building), and certain personal property associated with the use of real property (e.g., movable walls and furnishings). The Code and regulations elaborate on other types of interests that may constitute a USRPI for purposes of Sec. 897.5

For interests in domestic corporations, Sec. 897(c)(1)(A)(ii) provides:

(ii) [USRPI means] any interest (other than an interest solely as a creditor) in any domestic corporation unless the taxpayer establishes (at such time and in such manner as the Secretary by regulations prescribes) that such corporation was at no time a United States real property holding corporation during the shorter of —

(I) the period after June 18, 1980, during which the taxpayer held such interest, or

(II) the 5-year period ending on the date of the disposition of such interest.

Some important observations about Sec. 897(c)(1)(A)(ii) as it relates to interests in domestic corporations are worth noting. As a preliminary matter, an interest solely as a creditor in a domestic corporation is not a USRPI.6 Also, a domestic corporation generally is presumed to be a USRPHC unless the taxpayer establishes that such corporation was at no time a USRPHC during the relevant period (i.e., the shorter of the period the taxpayer held such interest or the five-year period ending on the date of such interest’s disposition). Failing to take this presumption into account when an NRA or foreign corporation sells stock in a domestic corporation can be a trap for the unwary.

A domestic corporation generally will be considered a USRPHC if the fair market value (FMV) of the USRPIs held by the domestic corporation on any applicable determination date equals or exceeds 50% of the sum of the FMV of its USRPIs, its interests in real property located outside the United States, and any other of its assets used or held for use in a trade or business.7 Only these types of assets are taken into account in making the USRPHC determination. Moreover, in determining whether any domestic corporation is a USRPHC, certain special rules will need to be considered when it owns interests in other corporations or entities, including flowthrough entities.8

For instance, a domestic corporation that holds a controlling interest (50% or more of the FMV of all classes of stock) in a second corporation generally will be treated as holding a portion of each of the second corporation’s assets equal to the percentage of the FMV of the second corporation’s stock held by the domestic corporation (Sec. 897(c)(5)(A)). In the case of a noncontrolling interest in a lower-tier corporation, such interest can be treated as a USRPI in the hands of the corporation being tested for USRPHC status if the lower-tier corporation is a real property holding corporation (there is a general presumption that it is).9 Further, a domestic corporation generally is treated as owning a proportionate share of the assets of a partnership, trust, or estate when it has an interest in such entities.10

The Code and regulations contain certain exceptions to the definition of a USRPI/USRPHC. An exception in Sec. 897(c)(1)(B) relates to a domestic corporation’s taxable purging of its USRPIs. Specifically, it provides:

(B) Exclusion for interest in certain corporations.—The term “United States real property interest” does not include any interest in a corporation if—

(i) as of the date of the disposition of such interest, such corporation did not hold any United States real property interests, and

(ii) all of the United States real property interests held by such corporation at any time during the shorter of the periods described in subparagraph (A)(ii) —

(I) were disposed of in transactions in which the full amount of the gain (if any) was recognized, or

(II) ceased to be United States real property interests by reason of the application of this subparagraph to 1 or more other corporations.11

Moreover, if any class of the domestic corporation’s stock is regularly traded on an established securities market, Sec. 897(c)(3) provides that stock of such class is treated as a USRPI only for a person who held more than 5% of that class of stock during the relevant period described in Sec. 897(c)(1)(A)(ii).12 Additional exceptions from the definition of a USRPI/USRPHC include interests in a domestically controlled qualified investment entity (e.g., a domestically controlled REIT) and certain interests in publicly traded partnerships and trusts.13

Applicable Determination Dates

A domestic corporation must make a determination about its status as a USRPHC on applicable determination dates. Taxpayers should pay close attention to Regs. Sec. 1.897-2(c), which provides detailed guidance and special rules relating to determination dates. Generally speaking, the applicable determination dates include (1) the last day of the domestic corporation’s tax year, (2) the date on which the domestic corporation acquires any USRPI, (3) the date on which the domestic corporation disposes of an interest in real property located outside the United States or disposes of other assets used or held for use in a trade or business during the calendar year, and (4) in the case of a domestic corporation that is treated as owning a portion of the assets held by an entity in which the corporation directly or indirectly holds an interest, the date on which that entity either acquires a USRPI, disposes of an interest in real property located outside the United States, or disposes of other assets used or held for use in a trade or business.14

Notwithstanding the above, the regulations also list certain types of transactions by the domestic corporation (e.g., its disposition of inventory or the disbursement of cash to meet regular business needs) and transactions by certain lower-tier entities that do not require a determination, as well as other special rules or testing dates that may modify some of the rules discussed.15 Moreover, the regulations permit a domestic corporation to determine its USRPHC status at the end of each calendar month and provide special rules and procedures if such an election is made (Regs. Sec. 1.897-2(c)(3)).

Establishing That a Domestic Corporation Is Not a USRPHC

Subject to certain limited exceptions relating to interests in certain domestically controlled REITs and certain regularly traded stock on an established securities market,16 a foreign person generally is presumed to be selling stock of a USRPHC unless that presumption is rebutted (Regs. Sec. 1.897-2(e)(1)). A foreign person may establish that its interest was not a USRPI as of the disposition date by requesting and obtaining from the domestic corporation a statement that the interest was not a USRPI as of that date or requesting a determination by the IRS.17 To qualify under the first method (i.e., requesting a statement from the corporation), the foreign person must obtain the corporation’s statement no later than the date, including any extensions, on which a tax return would otherwise be due with respect to the disposition.18 If the foreign person does not establish that the interest disposed of was not a USRPI, the interest is presumed to have been a USRPI disposition subject to Sec. 897(a). Moreover, a domestic corporation’s statement may not be valid for purposes of this rule unless the corporation complies with certain notice requirements (as discussed below) (Regs. Sec. 1.897-2(g)(1)(ii)).

A domestic corporation must, within a reasonable period after receipt of a request from a foreign person holding an interest in it, inform that person whether its interest constitutes a USRPI. For purposes of this determination, an interest in a corporation is a USRPHC if the corporation was a USRPHC on any determination date during the five-year period ending on the date specified in the interest-holder’s request, or on the date such request was received if no date is specified (or during such shorter period ending on the date applicable under Sec. 897(c)(1)(A)

(ii)). An interest in a corporation, however, is not a USRPI if such interest is excluded under Sec. 897(c)(1)(B) (Regs. Sec. 1.897-2(h)(1)(ii)). In addition, as part of the process, a domestic corporation that holds a noncontrolling interest in another corporation must determine whether that interest is a USRPI as of its own determination date.19 There is a presumption that it is, unless rebutted, and failure to take this presumption into account can be a trap for the unwary. The notice the domestic corporation provides to the foreign person needs to indicate only the domestic corporation’s determination because no particular form is required.20

If a domestic corporation provides a statement to the foreign person, the domestic corporation generally must also provide a notice to the IRS. The notice must include (1) a statement that the notice is provided under the requirements of Regs. Sec. 1.897-2(h)(2); (2) the name, address, and identifying number of the corporation providing the notice; (3) the name, address, and identifying number, if any, of the foreign interest holder that requested the statement (this information may be omitted from the notice if fully set forth in the statement to the foreign interest holder attached to the notice); (4) whether the interest in question is a USRPI; and (5) a statement signed by a responsible corporate officer verifying under penalties of perjury that the notice, including any attachments, is correct to his or her knowledge and belief (Regs. Sec. 1.897-2(h)(2)). A copy of any statement provided to the foreign interest holder must be attached to the notice. The notice must be mailed to the IRS on or before the 30th day after the statement is mailed to the interest holder that requested it. Failure to mail such notice within that time period will cause the statement to become invalid.21

Coordination with Sec. 1445

Unless an exception applies, Sec. 1445(a) requires withholding. Sec. 1445(b) provides several exemptions from Sec. 1445(a)’s general withholding requirement. For instance, the domestic corporation can give the transferee an affidavit under penalties of perjury that (1) the domestic corporation is not and has not been a USRPHC during the relevant period under Sec. 897(c)(1)(A)(ii) or (2) as of the disposition date, interests in such corporation are not USRPIs by reason of Sec. 897(c)(1)(B) (discussed above).22 In addition, Sec. 1445(b)(6) provides an exemption if the disposition is of a share of a class of stock that is regularly traded on an established securities market.23 If withholding is required, a transferee must report and pay any tax withheld by the 20th day after the transfer date. Forms 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, and 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests, are used for this purpose and must be filed at the location provided in the forms’ instructions.

Conclusion

This article highlights some issues to be considered whenever an NRA or foreign corporation sells stock of a domestic corporation. It must be emphasized, however, that such foreign persons and their tax advisers will need to carefully examine the rules in the Code and regulations (including the many special rules contained therein) to determine the sale’s tax consequences. This may require, in certain instances, obtaining necessary documentation to prevent the sale from being treated as income effectively connected with a U.S. trade or business.

Authors’ note: The opinions expressed in this article are those of the authors and do not necessarily reflect the views of their firm.


Notes

1 For instance, dividend distributions from a domestic corporation to an NRA or foreign corporation generally are subject to a gross basis 30% withholding tax, unless reduced by treaty. See generally Secs. 871, 881, 1441, and 1442. See Regs. Sec. 1.1441-3(c), especially clause (c)(2)(i)(C), for the amount of withholding on corporate distributions. Moreover, certain distributions that result in a foreign person recognizing gain on stock of a USRPHC (e.g., a Sec. 301(c)(3) distribution) may implicate Secs. 897 and 1445. Whenever a foreign person invests in certain qualified investment entities (i.e., certain real estate investment trusts (REITs) and regulated investment companies), certain rules, including special rules relating to distributions attributable to gains from sales of USRPIs, need to be considered. See generally Secs. 897(h) and 1445(e).

2 Stock is generally treated as personal property. Sec. 865(a) provides that, subject to certain exceptions listed in Sec. 865, income from the sale of personal property by a nonresident shall be sourced outside the United States. See also Regs. Sec. 1.865-2 dealing with loss with respect to stock. The Code and regulations also provide some guidance on the interaction of transactions in stock and being engaged in a U.S. trade or business; see, e.g., Sec. 864(b)(2) and Regs. Secs. 1.864-2(c), -4(c), and -5. A taxpayer should carefully review its transaction to determine whether any exception to the general rule mentioned in the text applies and whether its gain on the sale of domestic stock is brought within the U.S. taxing net; see, e.g., Sec. 871(a)(2).

3 The implication of a treaty (if any) would need to be considered. It is worth noting that Article 13 of both the 2006 and 1996 Model Income Tax Conventions generally permits the United States to tax a foreign person’s disposition of USRPHC stock.

4 For the definition of a foreign person, see Temp. Regs. Sec. 1.897-9T(c). Sec. 897(a) also applies to dispositions of USRPIs by foreign governments, except to the extent provided under the Sec. 892 regulations. For a recent notice discussing the interaction of Secs. 892 and 897, see Notice 2007-55, 2007-27 IRB 13. Special rules may also apply when a foreign person owns interests in certain types of entities that own USRPIs, such as partnerships; see, e.g., Secs. 865(i)(5) and 897(g) and Temp. Regs. Sec. 1.897-7T(a).

It also is worth noting that several different types of exchanges may implicate the rules under Sec. 897, including certain nonrecognition exchanges. See, e.g., Secs. 897(d) and (e) and Temp. Regs. Secs. 1.897-5T and -6T, as modified by certain notices (e.g., Notices 89-85 and 2006-46). A discussion of these issues is beyond the scope of this article.

5 See, e.g., Sec. 897(c)(6) and Regs. Secs. 1.897-1(b), (c), and (d).

6 For what constitutes an interest “solely as a creditor,” see generally Regs. Sec. 1.897-1(d).

7 See Sec. 897(c)(2) and Regs. Sec. 1.897-2(b) for further details. Per Regs. Sec. 1.897-2(b)(1), the term “interest in real property located outside the United States” means an interest other than solely as a creditor in real property located outside the United States or Virgin Islands. For purposes of determining FMV, see Regs. Sec. 1.897-1(o). An alternative test may apply when the FMV of a corporation’s USRPIs is presumed to be less than 50% of the FMV of the aggregate of its assets described in Regs. Secs. 1.897-2(d) and (e) if, on an applicable determination date, the total book value of the USRPIs held by the corporation is 25% or less of the book value of the aggregate of the corporation’s assets described in Regs. Secs. 1.897-2(d) and (e). For further details and special rules relating to the book value test, see Regs. Sec. 1.897-2(b)(2).

8 See, e.g., Secs. 897(c)(5) and (c)(6) and Regs. Secs. 1.897-2(d) and (e).

9 See Regs. Sec. 1.897-2(g)(2). See Regs. Sec. 1.897-2(g)(3) for exceptions to the general presumption rule. If the lower-tier corporation is not a real property holding corporation, such interest often will not be taken into account in the USRPHC analysis. It should be recognized, however, that Regs. Sec. 1.897-2(e)(1) provides that, for purposes of determining whether any corporation is a USRPHC, an interest in a foreign corporation is treated as a USRPI unless it is established (as provided in the regulations) that the interest was not a USRPI on the applicable determination date.

10 See Sec. 897(c)(4)(B). For further details on this rule and an exception for trade or business assets of certain investment companies, see Regs. Sec. 1.897-2(e)(2). See Regs. Sec. 1.897-2(e)(4) for coordinating these rules.

11 See also Regs. Sec. 1.897-2(f)(2) for further details.

12 See also Sec. 897(c)(6)(C), which uses certain constructive ownership rules in applying the more-than-5% test, and Regs. Secs. 1.897-1(m), -2(g)(3), and -9T, which provide further guidance.

13 For further information on these exceptions, see Secs. 897(h)(2) and (h)(4) and Regs. Sec. 1.897-1(c)(2).

14 Regs. Sec. 1.897-2(c)(1). The first determination of a corporation’s status need not be made until the 120th day after the later of the incorporation date or the date on which the corporation first acquires a shareholder. Further, a special rule also applies to a liquidating corporation. Id. For valuation date methods, including a rule that permits an alternative valuation date method for determination dates other than the last day of the tax year, see Regs. Sec. 1.897-2(c)(4).

15 For further details, see Regs. Sec. 1.897-2(c).

16 This exception for regularly traded stock on an established securities market will not apply if the foreign person has held a more-than-5% interest in the domestic corporation during the period described in Sec. 897(c)(1)(A)(ii). See Regs. Sec. 1.897-2(g)(3) for further details on these exceptions.

17 For details and procedures on requesting an IRS determination, see Regs. Sec. 1.897-2(g)(1)(iii). Under this option, the foreign person generally will need to pay the tax and request a refund.

18 Regs. Sec. 1.897-2(g)(1)(ii). If a foreign person requests and obtains such a statement, it is not required to take any further action to establish that the interest is not a USRPI. Id. For further details and other special rules (e.g., if it is determined that the interest actually was a USRPI), see generally Regs. Sec. 1.897-2(g)(1)(ii). A foreign seller should consider the timing of the request in conjunction with the withholding rules under Sec. 1445. The IRS has granted 9100 relief in certain cases of failures to obtain the necessary statements. See, e.g., IRS Letter Ruling 200718017 (5/4/07).

19 Regs. Sec. 1.897-2(g)(2). This determination may be made by obtaining a statement from the second corporation under the provisions of Regs. Sec. 1.897-2(g)(2)(ii), obtaining an IRS determination under Regs. Sec. 1.897-2(g)(2)(iii), or making an independent determination under Regs. Sec. 1.897-2(g)(2)(iv). For further details, see Regs. Sec. 1.897-2(g)(2). See Regs. Sec. 1.897-2(g)(3) for exceptions to this general rule.

20 Regs. Sec. 1.897-2(h)(1)(i). The statement must be signed by a responsible corporate officer and must be under penalties of perjury. Id.

21 The requirements above are not applicable to certain domestically controlled REITs and to corporations any class of whose stock is regularly traded on an established securities market at any time during the calendar year (Regs. Sec. 1.897-2(h)(3)). There are also a number of other special rules relating to providing voluntary notice to the IRS (which may exempt such corporations from the requirements of Regs. Sec. 1.897-2(h)(2)) and supplemental filings that will need to be considered. See generally Regs. Secs. 1.897-2(h)(4) and (h)(5).

22 See Sec. 1445(b)(3). In addition, Regs. Sec. 1.897-2(g)(1)(ii)(B) provides that, under Sec. 1445 and the regulations thereunder, withholding tax is not required for a foreign person’s disposition of an interest in a domestic corporation if the transferee is furnished with a statement by the corporation under Regs. Sec. 1.897-2(h) that the interest is not a USRPI.

23 For further guidance on this exemption and a possible expansion of the rule, see Regs. Sec. 1.1445-2(c)(2). For other exemptions, limitations, and special rules on withholding, see generally Sec. 1445 and the regulations thereunder.

 

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